How to Properly Terminate a 401k Plan

A 401(k) plan allows employees to contribute a portion of their income on a tax-deferred or Roth basis, often with employer contributions, for retirement savings. While generally permanent, companies may terminate a 401(k) plan due to business closure, merger, acquisition, or a strategic decision to transition to a different retirement benefit. The decision to terminate a 401(k) plan initiates a structured process that involves careful adherence to regulatory requirements and diligent management of participant assets.

Initial Preparations for Plan Termination

Before formally terminating a 401(k) plan, a series of preparatory steps are necessary to ensure a smooth and compliant process. The decision to terminate must be formally documented, typically through a board resolution or other corporate action, establishing a specific termination date. This action signals the cessation of plan contributions and triggers full vesting for all participants on that date, regardless of their prior vesting schedule.

Review the existing plan document to identify specific termination clauses and ensure it’s updated with all required legal and regulatory amendments. Any necessary plan amendments must be adopted before the termination becomes effective. Address all outstanding plan issues, ensuring all employer and employee contributions due up to the termination date have been remitted. Uncashed distribution checks and participant loans require particular attention; loans typically become due upon termination, with any unpaid balance treated as a taxable distribution.

Notify participants about the impending termination. This notification should inform them of the plan’s termination, the established date, and the implications for their accounts, including distribution options. This allows participants to understand their choices and prepare for benefit distribution. Engaging professional advisors, such as third-party administrators (TPAs), legal counsel, and accountants, is highly recommended. These professionals offer expertise in navigating the regulatory landscape, ensuring compliance, and assisting with accurate data management. Gather all necessary plan records and participant data, including historical contribution records, distribution history, and compliance testing results, for accurate benefit calculations and regulatory filings.

Executing the Termination Process

After initial preparations, executing the 401(k) plan termination involves specific regulatory actions and filings. An optional step is requesting an IRS determination letter by filing Form 5310, “Application for Determination for Terminating Plan.” This application asks the IRS to confirm the plan’s qualified status through the termination date. While the IRS charges a fee for this review, and the process can take several months, it can identify potential compliance issues.

After the termination date, final contributions must be made, and all plan accounts need to be reconciled. This includes allocating any remaining forfeiture accounts, which may be used to pay plan administration expenses or be reallocated to participants, according to the plan document. All plan assets must then be prepared for distribution to participants, which may involve liquidating investments.

A mandatory step is filing a final Form 5500, Annual Return/Report of Employee Benefit Plan. This form notifies the Department of Labor (DOL) and the IRS that the plan has ceased operations. The final Form 5500 must be filed by the last day of the seventh month after all plan assets have been distributed, and it must indicate a $0 balance. Until all assets are fully distributed and the final Form 5500 is filed, the plan is considered ongoing, requiring continued compliance.

Managing Participant Distributions

Once termination steps are underway and assets are ready, managing participant distributions becomes the primary focus. Participants have several options for receiving their vested benefits. They can elect a direct rollover, transferring their account balance directly to an Individual Retirement Account (IRA) or to another employer’s qualified retirement plan. A direct rollover avoids immediate taxation and allows the funds to continue growing tax-deferred. Alternatively, participants can opt for a lump-sum cash distribution.

A cash distribution has immediate tax implications. The distributed amount is generally taxed as ordinary income in the year received. If the participant is under age 59½, the distribution may also be subject to an additional 10% early withdrawal penalty, unless an exception applies. Common exceptions to this penalty include separation from service at age 55 or later, death, disability, or distributions for certain unreimbursed medical expenses. A mandatory 20% federal income tax withholding applies to eligible rollover distributions not directly rolled over.

Before distributions are made, plan administrators must provide participants with a Special Tax Notice Regarding Plan Distributions, also known as a 402(f) notice. This notice explains the rollover options, the tax consequences of various distribution choices, and information about the 20% mandatory withholding. It must be provided within a reasonable timeframe, generally between 30 and 180 days, before the distribution is made. Following the distributions, Form 1099-R, which reports retirement plan distributions, must be issued to participants by January 31 of the year following the distribution.

Handling missing or unresponsive participants requires specific strategies to ensure all assets are distributed. For small balances, generally under $5,000, the plan may be able to force an automatic rollover to an IRA established on the participant’s behalf, particularly if the participant does not elect a distribution after receiving proper notice. For balances under $1,000, some plans may allow for a direct cash-out. Diligent efforts, such as using certified mail, checking related plan records, and contacting beneficiaries, should be made to locate missing individuals before resorting to automatic rollovers or other default actions. All distributions should be completed as soon as administratively feasible, generally within one year of the plan termination date.

Post-Termination Responsibilities

After all plan assets are distributed and the formal termination process is complete, certain responsibilities persist for the plan sponsor. Record retention is a significant ongoing obligation. All plan documents, participant records, and termination-related filings, including the formal resolution to terminate, participant notices, and final Form 5500, must be retained for specific periods. While specific durations can vary, ERISA generally requires records to be kept for at least six years after the filing date of a report. Other records, such as basic plan documents, may need to be retained indefinitely to demonstrate compliance with qualification requirements.

Lingering issues or inquiries from participants or regulatory bodies may arise even after the termination. The plan sponsor should be prepared to address these, providing necessary information or clarification as needed. This includes responding to questions about distributions, tax forms, or the finality of the plan. Confirming the finality of the termination with all relevant parties, including service providers, helps ensure that no administrative tasks or liabilities remain outstanding. The ultimate goal is to have zero remaining plan assets or liabilities, signifying a complete and compliant termination.